Financial Management for Non-Financial Managers

Pacific Training Innovations Ltd Financial Management for Non-Financial Managers Part: 2 Financial Analysis: Analyzing the Financial Health of Your Business Presented By: Bill Erichson 2010 Pacific Training Innovations Ltd.

FINANCIAL ANALYSIS Analyzing the Financial Health of your Business Financial analysis is one of the most important aspects of business planning. Unfortunately, many businesses people neither use, nor understand the value of this financial analysis. This is a pity, because Financial Analysis is a diagnosis of the financial health of the company; providing valuable information on the company s strengths and weaknesses. Entrepreneurs often ignore financial information simply because they do not understand the business insights they provide. Many people think that financial analysis is difficult and theoretical. This can be true; however, there are many simple calculations you can perform on your Balance Sheets and Income Statements. These provide valuable information about your business. This seminar is more than a financial seminar; it is a business strategies seminar. By analyzing the financial health of the business, you see the business strategies that led the current financial situation. This includes marketing, operational and human resources strategies. The financial analysis is the first step in the business planning process. There is a great deal to learn about the entire business simply by analyzing and interpretation of your financial statements. RATIO ANALYSIS One simple, yet effective form of Financial Analysis is Ratio Analysis. A ratio is simply one number divided by another number. Common examples are goals against average in hockey, student/teacher ratio, in education, or kilometers per hour on the highway. Ratios in themselves mean nothing. For example, 50 KPH is not very fast on the freeway (rush hour notwithstanding) but is very fast if you are running! All ratios, financial ratios included, are compared to something else in order to make any sense. Typically, we compare financial ratios to three things: o o o Previous Years (Historic) Industry Averages (External Benchmarks) Internal Goals (Internal Benchmarks) Ratios are also important to a business start up situation. In order to plan effectively it is wise to compare your projections to industrial averages. If for example, you are starting a Ladies Clothing Store, and your projection reveals a Gross Profit percentage of 60%, you are being very optimistic, for the industry average is only about 42%. You can get benchmarks from your larger public libraries. The Vancouver Public Library has such benchmarking books; however, they are in the reference section. You may call your local librarian for more information. In this session, we will analyze a set of financial statements, and then determine the company s strengths and weaknesses. You will discover how they got into the situation they are currently in, and how to get them back on track 2010 Pacific Training Innovations 2

PACIFIC WIDGETS INCOME STATEMENT Year 1 Year 2 Year 3 Year 4 Revenue $ 500,000 100.0% $ 750,000 100.0% $ 1,100,000 100.0% $ 1,350,000 100.0% Cost Material $ 150,000 $ 225,000 $ 335,500 $ 414,450 Cost of Labour $ 125,000 $ 210,000 $ 313,500 $ 411,750 $ 275,000 $ 435,000 $ 649,000 $ 826,200 Gross Profit $ 225,000 $ 315,000 $ 451,000 $ 523,800 Overheads 0.0% Advertising $ 6,000 1.2% $ 9,000 1.2% $ 15,000 1.4% $ 20,000 1.5% Depreciation $ 30,000 6.0% $ 35,000 4.7% $ 47,500 4.3% $ 56,250 4.2% Automobile $ 7,000 1.4% $ 10,000 1.3% $ 13,000 1.2% $ 20,000 1.5% Bad Debt $ 5,000 1.0% $ 7,500 1.0% $ 12,000 1.1% $ 15,000 1.1% Building Rent $ 55,000 11.0% $ 55,000 7.3% $ 60,000 5.5% $ 60,000 4.4% Insurance $ 8,500 1.7% $ 12,750 1.7% $ 20,400 1.9% $ 25,500 1.9% Interest $ 7,500 1.5% $ 12,500 1.7% $ 17,500 1.6% $ 20,500 1.5% Office Supplies $ 1,000 0.2% $ 1,500 0.2% $ 2,400 0.2% $ 3,000 0.2% Professional Fees $ 2,000 0.4% $ 3,000 0.4% $ 4,800 0.4% $ 6,000 0.4% Taxes & Licenses $ 1,500 0.3% $ 2,250 0.3% $ 3,600 0.3% $ 4,500 0.3% Telephone $ 2,000 0.4% $ 3,000 0.4% $ 4,800 0.4% $ 6,000 0.4% Utilities $ 9,500 1.9% $ 14,250 1.9% $ 22,800 2.1% $ 28,500 2.1% Wages & Benefits $ 79,500 15.9% $ 119,250 15.9% $ 190,800 17.3% $ 238,500 17.7% Misc. $ 3,500 0.7% $ 5,500 0.7% $ 8,500 0.8% $ 11,000 0.8% Total Overheads $ 218,000 43.6% $ 290,500 38.7% $ 423,100 38.5% $ 514,750 38.1% Net profit $ 7,000 1.4% $ 24,500 3.3% $ 27,900 2.5% $ 9,050 0.7% 2010 Pacific Training Innovations Ltd.

PACIFIC WIDGETS BALANCE SHEET (WITH % TO ASSET RATIO) Year End 1 Year End 2 Year End 3 Year End 4 Cash $ - 0.0% $ - 0.0% $ - 0.0% $ - 0.0% Accounts Receivable $ 70,000 28.0% $ 105,000 27.6% $ 160,000 29.4% $ 225,000 32.6% Inventory $ 35,000 14.0% $ 80,000 21.1% $ 155,000 28.4% $ 220,000 31.9% Prepaid Expenses $ 5,000 2.0% $ 5,000 1.3% $ 5,000 0.9% $ 5,000 0.7% Current Assets $ 110,000 44.0% $ 190,000 50.0% $ 320,000 58.7% $ 450,000 65.2% Capital Assets $ 140,000 56.0% $ 190,000 50.0% $ 225,000 41.3% $ 240,000 34.8% Total Assets $ 250,000 100.0% $ 380,000 100.0% $ 545,000 100.0% $ 690,000 100.0% Accounts Payable $ 12,500 5.0% $ 20,000 5.3% $ 30,000 5.5% $ 50,000 7.2% Line of Credit $ 30,500 12.2% $ 98,500 25.9% $ 185,600 34.1% $ 261,550 37.9% Current Portion of Term Debt $ 20,000 8.0% $ 25,000 6.6% $ 35,000 6.4% $ 50,000 7.2% Current Liabilities $ 63,000 25.2% $ 143,500 37.8% $ 250,600 46.0% $ 361,550 52.4% Term Debt $ 110,000 44.0% $ 140,000 36.8% $ 180,000 33.0% $ 220,000 31.9% Less Current Portion $ (20,000) $ (25,000) $ (35,000) $ (50,000) Total Liabilities $ 153,000 61.2% $ 258,500 68.0% $ 395,600 72.6% $ 531,550 77.0% Owners' Equity $ 90,000 36.0% $ 97,000 25.5% $ 121,500 22.3% $ 149,400 21.7% Retained Earnings $ 7,000 2.8% $ 24,500 6.4% $ 27,900 5.1% $ 9,050 1.3% Total Equity $ 97,000 38.8% $ 121,500 32.0% $ 149,400 27.4% $ 158,450 23.0% Liabilities & Equity $ 250,000 100.0% $ 380,000 100.0% $ 545,000 100.0% $ 690,000 100.0% 2010 Pacific Training Innovations Ltd.

CASE STUDY PACIFIC WIDGETS Pacific Widgets makes widgets from the finest British Columbia wood products. The widgets are carefully honed on specially designed computerized lathes and then polished with high quality widget polish an unique combination of cedar oil and beeswax. Over the past four years, this company has grown dramatically, and has engaged in a rapid expansion program. Although the company is profitable, the cash flow is now a problem. Your job is to analyze the company s financial statements and help the owner know why a growing, profitable company is in financial difficulty INCOME STATEMENT ANALYSIS Percent to sales Dollar Change Ratio Formula Explanation Percentage Change Expense (or Profit) Annual Revenue Current Year Previous Year (Current Year-Previous Year) Current Year This tells us the number of cents spent for every dollar of revenue. For example, if the percent to sales ratio is 10%, then for every dollar in revenue, 10 cents went to advertising. This is the change, in dollars of expenses between years. This is the dollar change expressed as a percentage of the current year. Calculate the Missing % to sales ratios on the Income Statement. Calculate the Percentage Change in: Revenue Gross Profit Overhead Costs Net Profit Percentage change in Revenue Percentage change in Gross Profit Percentage change in Overheads Percentage change in Net Profit Year 1 to Year 2 Year 2 to Year 3 Year 3 to Year 4 What do we learn from the percentages we do not learn from the raw numbers? What are the potential causes of the drop in gross profit? 2010 Pacific Training Innovations Ltd.

BALANCE SHEET RATIOS Working Capital is an early measure of cash flow problems. The working capital is the equity portion of financing used to finance current assets inventory and accounts receivable. The debt to equity ratio sums up how the business is being financed. Sometimes, we express these ratios as a percentage, however, sometimes we express them as the ratio: 1. For example, working capital of 2:1 means that for every dollar in current liabilities, there are$2 in current assets. Ratio Formula Explanation Working Capital Ratio Current Assets Current Liabilities This looks at how much equity is used to finance working capital. (Working capital is Current Assets Current Liabilities) It is expressed as a percentage or as a Dollar amount (i.e. $2.66: 1) Quick Ratio Debt Equity Ratio (Current Assets Inventory) Current Liabilities (Liabilities Shareholders Loans) (Equity + Shareholders Loans) The quick ratio is used with the working capital ratio to measure liquidity. It factors out the inventory as the inventory is less liquid than other current assets. This is particularly important to banks. This ratio tells you how the business is currently financed. High debt to equity ratios mean that creditors are financing the business, whereas low debt to equity ratios indicate that the business is financed internally. Calculate the Balance Sheet Ratios for Pacific Widgets. Working Capital Quick Ratio Debt Equity Year 1 Year 2 Year 3 Year 4 What does the change in these ratios tell you about the financial health of Pacific Widgets? What changes do you notice that may have caused this problem? 2010 Pacific Training Innovations 6

THE TURNOVER RATIOS These measures provide details on working capital, and the current asset conversion cycle. Ratio Formula Explanation Inventory Turnover Days Inventory Cost of Materials Inventory 365 Inventory Turnover Measures the number of times inventory is replaced, or the number of days inventory remaining. Note: An alternative is to use average inventory, receivable and payables from the last balance sheets. That would be (Current Year + Previous Year)/2 Accounts Receivable Turnover Accounts Receivable Days (Collection Period) Accounts Payable Turnover Accounts Payable Days Sales Accounts Receivable 365 Accounts Receivable Turnover Cost of Materials Accounts Payable 365 Accounts Payable Turnover Measures the number of times the receivables are replaced or the average number of days it takes to collect your accounts receivable. Measures the number of times payables are replaced or the number of days it takes to pay an account receivable. 2010 Pacific Training Innovations 7

CURRENT ASSET CONVERSION CYCLE The Current Asset Conversion Cycle is the process by which cash is turned into raw materials, finished goods, sales (accounts receivable) and then back into cash. Using the answers to the turnover ratios, you can determine the Current Asset Conversion Cycle 1 for Pacific Widgets. Calculate the following ratios for Pacific Widgets. Financial Ratio Year 1 Year 2 Year 3 Year 4 Inventory Turnover Ratio Accounts Receivable Turnover Accounts Payable Turnover Inventory Days Accounts Receivable Days Accounts Payable Days Days Credit Required What does this tell us about the current asset conversion of Pacific Widgets? What are potential reasons for low inventory turnover? What are potential reasons for low accounts receivable turnover? 1 For more on the Current Asset Conversion Cycle, see the Interpretation of financial ratios section at the end of these notes 2010 Pacific Training Innovations 8

RETURN ON ASSETS & RETURN ON OWNER S EQUITY Return ratios are about the profit. Return on Assets tell us how effectively the company has employed the assets under management s control. Ratio Formula Explanation Return on Assets (ROA) Net Profit Total Assets Return on assets compares the net profits to the total assets. It is a measure on how effectively the management of the company is using the financial resources of the business. Return on Owners Equity (ROI) Net Profit Owners Equity The return on equity tells us how much the owners have received as a return on their investment in the business. It shows how hard the investment is working. Calculate the ROA and ROI for Pacific Widgets Ratio Year 1 Year 2 Year 3 Year 4 Return on Assets (ROA) Return on Owners Equity (ROI) What do you learn about the returns for Pacific Widgets? How can you explain a dropping ROA? What recommendations would you make to Pacific Widgets as they go into their next fiscal year. 2010 Pacific Training Innovations 9

Interpretation of Ratios You must see financial ratios in context to understand the true state of your business. Different industries, different stages of growth and specific situation can lead to a misinterpretation of the result provided by the analysis. The following section highlights just some situations that you should consider as a part of diagnosing the financial health of your business. PERCENT TO SALES RATIOS AND PERCENTAGE GROWTH RATIOS (THE INCOME STATEMENT) The income statement, and the percent to sales ratio, is the most fundamental of all business measures. There are a few issues you should consider when considering the income statement analysis. There are three distinct parts to an income statement; the revenue section, the cost of goods section and the business overheads section. Here are some things to consider when analyzing the income statement. 1. The accountant prepared income statement may not provide the same number of revenue streams as will your accounting system. In companies with several different income streams (think of departments in a retail store) it is worthwhile to analyze your sales by department. This may mean drilling down using your accounting system. 2. Always look carefully at the sales in the last month of the fiscal year, especially if you have a work in progress adjustment. Large jobs at the end of the fiscal year can make sales look higher, or lower than normal depending on the period in which the revenue is recognized. This can make your business appear to have grown or contracted when it is stable. The same can happen if you are using the modified accrual method. This allows a service business to defer recognition of project income until the project is complete. Although this is a tax issue, your accountant prepared statements reflect the tax strategy. 3. If you are analyzing interim statements without the benefit of an inventory count, then purchases reflect cost of materials. If you have purchased a great deal of inventory, or allowed your inventory to decrease, the cost of goods will not be accurate. Make an adjustment when interpreting your results. 4. We expense labour when we complete the work, however, if you are working on a project, your revenue may not be timed to the expense. This can mean early recognition of labour reducing your gross profit. Keep this in mind when analyzing your statements and preparing your year-end. Let your accountant know, as she may want to make adjustments before preparing your financial statements. 5. Sometimes a company has non-recurring costs. For example, a onetime charge for developing a website, moving locations or a large severance payout. This reduces your profit, but it is not systematic. For analysis purposes, subtract these non-recurring expenses before analyzing the income statement, or alternatively, compute the percent to sales both including and excluding the non-recurrent costs. 6. Add back any bonus expensed for personal recognition in the next calendar year. This is a false cost used for tax purposes. 7. In a service business, or small manufacturing business, your labour costs change as owners are not generally accounted for in the cost of goods section. This can give a false sense of increasing labour costs. You are simply using less free labour, namely your own. 2010 Pacific Training Innovations 10

THE BALANCE SHEET Since the balance sheet is a snapshot of your business, they reflect the conditions when the picture was taken. Sometimes, this does not create a complete picture. Here are some things to watch out for when analyzing your balance sheet. Working Capital Ratio (Liquidity Ratios) Look for any last minute sales or purchases, which give a false impression with respect to your current assets. For example, a very large sale at the end of the year would result in a large account receivable. This would make your collection period appear higher than it really is. The same is true if you increase your inventory for a specific job. The analysis may say you have 180 days inventory, however, you know that you will use it all within 45 days to fulfill this sale. Quick Ratio (Acid Test) The quick ratio discounts the inventory from the numerator without discounting the accounts payable from the denominator. If you have increased inventory and it is financed by the supplier, you may not have as big a change as the ratio analysis suggests. Although this is uncommon, it does happen and must be considered when interpreting the quick ratio. Debt to Equity Ratios There are several variations on this theme. In our session, we have included the total debt to equity ratio; however, there are some variations to this theme. It is important to remember to include the shareholders loans as equity for analysis purposes unless they are being repaid from ongoing company funds. Ratio Formula Notes (Total Liabilities Shareholders Loans) Expresses the proportion of financing Total Debt Equity (Owners Equity+ Shareholders Loans) from the owners vs. creditors. Expresses the long term financing from Long Term Debt Long Term Debt (including Current Portion) lenders from the investment from the Equity (Owner s Equity+ Shareholders Loans) owners. Bank Debt to Equity Total Bank Debt (Owner s Equity+ Shareholders Loans) Expresses the bank s risk in the business. (The remaining liabilities are usually unsecured, and therefore have less impact on the bank s risk situation. 2010 Pacific Training Innovations 11

CURRENT ASSET CONVERSION CYCLE Current Asset conversion is one of the single most important principles in business. The current asset conversion cycle tracks the financing required to bring a product from purchase through collection. Consider the following flow as illustrated in the diagram below: Step Activity Effect on Financing A Inventory is purchased for either resale or processing. This is financed by the supplier unless it is a cash purchase. B The supplier is paid. This is financed with either existing cash, which itself is financed, or by using the Line of Credit. C The Product is sold on credit terms. The financing continues as no cash has entered the business. The noninventory costs, including labor, overhead and profits are being finances. D The account is paid. The cash re-enters the system and the company can finance future activities. Figure 1 - Current Asset Conversion In some businesses, you can actually purchase, sell and collect before you pay your suppliers. This is called negative working capital. The longer the period between B and D, the more cash is needed to operate the business. Cash already in the A B C D Purchase to Payment financial challenges to a growing business. Inventory Turnover & Days Non-Supplier Financing Purchase To Sale Bank or Equity Financing Sales to Collection business or a line of credit are the most common methods of financing current assets until they are liquidated, or turned into cash. Working Capital financing is one of the most critical aspects of business finance, and one of the greatest As mentioned in the Working Capital notes look for spikes in the inventory levels for a good reason such as a sale. When sales are trending up, the days inventory is overstated because we base the inventory use rate on the previous year s sales. Two common errors affecting inventory levels are over buying to get a better price (great for profit, bad for cash flow) and failing to dispose of obsolete inventory. Financial analysis can reveal the problem, but inventory management and accurate purchasing is the solution. Do this by using an open to buy in retail or a production schedule in manufacturing. Some businesses, calculate separate inventory turnover for each department or category. This is very common in retailing. This way, you can manage inventory and purchasing policies with far more accuracy. 2010 Pacific Training Innovations 12

It is more accurate to use the average inventory. Use the formula: Average Inventory = In some cases, businesses track inventory every month, and you can average your inventory for the year, beginning with the beginning of year inventory, and then adding the inventory level at the end of each month and dividing by 13 to get an annual average inventory. For year on year comparison purposes, yearend inventory provides a consistent mark to measure annual changes. Accounts Receivable Days & Turnover Managing the Accounts Receivable is another essential part of the working capital and cash flow. The accounts receivable is always calculated at year-end and on the sales to the date of the income statement. If there is an increase in the Accounts Receivable Days (also called the collection period) then it is important to produce an aged receivables list. This is a common report on most accounting programs. It is important to write off bad debt on a timely basis. This reduces both your Income Tax and HST tax liability. Increases in your collection period often reflect either a credit policy problem or collections problem. If your accounts receivables increased due to a large sale in the last month of the year, you get a false reading of your collection period. Accounts Payable and Turnover (Previous Years Inventory + Current Year s Inventory) 2 Your payables represent the way in which your suppliers are financing your business. Changes in the AP turns are often early indicators of problems in the business acting as the canary in the coal mine. Just as with inventory, large purchases at year-end can skew this number. RETURN RATIOS Return on Assets (ROA) This is straight forward, and shows the efficiency of the use of assets. Falling ROA can indicate inefficiencies or excess capacity. Examine ROA over the long term. For example, when purchasing assets to increase productivity, a company may have a lower ROA until the enterprise utilizes the capacity. When the ROA is constantly dropping, there is the indication that either there is a profitability problem, or there are excess assets, which are not producing additional profits. Cash rich companies often have large reductions on ROA even when profits are strong. The company is making sufficient profits that the assets within the company are increasingly cash and the cash is not providing the return generated by the operating businesses. Sometimes, you can subtract the Marketable securities and short-term investments from the asset base and only include operating profits in the numerator. It is preferable to add owners bonuses used to defer income tax back into profit for financial analysis purposes. 2010 Pacific Training Innovations 13

Return on Investment (ROI) Return on investment has many of the same characteristics as the ROA calculation. Sometimes the ROI drops as owners reduce their debt and increase their equity. This deleveraging usually reduces ROI because the current cost of borrowing is very low. There is a personal and philosophical reason for debt reduction that often is a matter of personal preference rather than a pure business decision. Suppose an investor purchases a piece of land for $120,000 and borrows $100,000 over 20 years. He then leases the land for 20 years for $ 8,024 per year, the exact amount of his loan payment. Each year, the profit equals the principal repayment of the loan. Notice that each year the ROA increases, as the profits rise since the interest costs are dropping, however, the ROI decreases, as the investment is de-levered. Use these ratios carefully, as there are many factors, which change ROA & ROI. SO WHAT NOW? Year Debt Equity Profit ROI ROA 1 $96,975.74 $23,024.26 $3,024.26 13.1% 2.5% 5 $83,289.06 $36,710.94 $3,676.01 10.0% 3.1% 10 $61,961.20 $58,038.80 $4,691.62 8.1% 3.9% 15 $34,740.84 $85,259.16 $5,987.83 7.0% 5.0% 20 $0.00 $120,000.00 $7,642.15 6.4% 6.4% Analysis reveals the health of the business. This is why a strong diagnostic is the first step in planning. By looking at the financial implications of your business strategies, you are better able to change strategies, better execute existing strategies and keep strategies that allow you to achieve your business goals. The next step in the planning process is Forecasting Revenues, Expenses and Cash Flow. 2010 Pacific Training Innovations 14

THE ANSWERS (NO PEEKING) Income Statement Ratios Year End 1 Year End 2 Year End 3 Year End 4 Material % 30.0% 30.0% 30.5% 30.7% Labour % 25.0% 28.0% 28.5% 30.5% COG % 55.0% 58.0% 59.0% 61.2% Gross Profit % 45.0% 42.0% 41.0% 38.8% Change Ratios Year 1 to 2 Year 2 to 3 Year 3 to 4 Revenue 33.3% 31.8% 18.5% Gross Profit 28.6% 30.2% 13.9% Overheads 25.0% 31.3% 17.8% Net Profit 71.4% 12.2% -208.3% Balance Sheet Ratios Working Capital 1.75 1.32 1.28 1.24 Quick Ratio 1.19 0.77 0.66 0.64 Debt Equity 1.58 2.13 2.65 3.35 Turnover Ratios Inventory Turns 4.29 2.81 2.16 1.88 AR Turns 7.14 7.14 6.88 6.00 AP Turns 12.00 11.25 11.18 8.29 CACS Days Inventory Days 85 130 169 194 AR Days 51 51 53 61 AP Days 30 32 33 44 Return Ratios ROA 2.8% 6.4% 5.1% 1.3% ROI 7.2% 20.2% 18.7% 5.7% 2010 Pacific Training Innovations 15

PACIFIC TRAINING INNOVATIONS LTD Pacific Training Innovations Ltd. helps small business owners all over British Columbia, across Canada and into the United States. From our 1992 beginnings as a training organization, the company quickly evolved into a complete resource for small business financing and planning. We help your business three ways: Bookkeeping and Financial Administration Business training Business planning and advisory services Bill Erichson is a noted business trainer, consultant and business planner and founder of Pacific Training Innovations Ltd. He has over twenty years of experience helping small and medium sized business owners grow develop their businesses. Bill's approach blends the development of the Marketing, Operational, Financial, and Human Resource aspects of the business. Unlike the 'specialist' approach of many business advisors, Bill determines the next strategic direction required for the development of the business, and plans around the Key Business Sector as developed through a detailed business diagnosis. Bill is an author and instructor, having developed materials in planning, finance, and marketing. Bill graduated from Simon Fraser University in Commerce and Mathematics, and has worked in retail, banking and service industries. Contact Bill at: Pacific Training Innovations Ltd. #201 1405 Hunter Street North Vancouver. BC 604.924.0055 pactrain@shaw.ca 2010 Pacific Training Innovations 16